Margin Of Safety is the essence of Value Investing — an investing philosophy which focuses on the preservation of capital. Value investors are ‘buy and hold’ investors who look for companies where the fundamentals (and other factors) suggest that the current share price does not reflect the intrinsic or true worth of the company or its shares. (In value investing terms, share prices are either under-priced or over-priced relative to the intrinsic value of the business and not to the stock market as a whole.) The gap between a company’s current share price and what the value investor believes it ought to be is known as the ‘Margin Of Safety’. So if the true worth of a company is say £100 Million and the current market capitalisation is £70 Million, then a 30% margin of safety exists. There is no universal rule which states exactly how wide the margin should be but the larger the gap is, the more the downside risk is minimised. The purpose therefore of the Margin Of Safety is to cushion an investor against any errors they make in their calculations, exercising their own but incorrect judgement and market downturns.
Intrinsic value can be defined (there are other definitions) as what a business would be worth to the owner, or indeed a potential buyer, based on its own merits and irrespective of a share’s closing, opening, asking or bidding price, or the market’s opinions, moods or trends. But determining the real worth of the shares of a neglected, misunderstood or unpopular company is far from easy. Investors will look at the company’s fundamentals such as its EPS, cash flow, EG, ROIC etc, plus a company will sometimes have hidden assets or unquantifiable attributes which are almost impossible to value.
(Value investors do not subscribe to the belief that stock markets are efficient as those investors who subscribe to the efficient market hypothesis (EMH) do. According to the EMH, a share’s price directly reflects all the information that’s available in the public domain about that business. Furthermore, the price will change — barring ‘accidents’ — only when new information about the business emerges. In other words, the current market price is almost always equal, or close to, the company’s intrinsic value.)